Iron Ore What? (IOW) Casting Company is considering adding a new line to its pro

Question

Iron Ore What? (IOW) Casting Company is considering adding a new line to its product mix. Sydney Johnson, a recently minted MBA, will be conducting the capital budgeting analysis. The new production line would be set up in unused space in IOW’s main plant. The machinery invoice price totals approximately $250,000, with another $20,000 in shipping charges and $30,000 to install the equipment, for a total requirement estimated at $300,000. The machinery has an economic life of 4 years, and IOW has obtained a special tax ruling that places the equipment in the Modified Accelerated Cost Recovery System (MACRS) 3-year class. After 4 years of use the machinery is expected to have a salvage value of $25,000. The new product line would generate incremental sales of 1,350 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 each in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by an amount equal to 15% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 12%.

1. IOW typically adds or subtracts 5 percentage points to the overall cost of capital to adjust for risk. Given this consideration, should the new line be accepted? Explain.

Explanation / Answer

INITIAL INVESTMENT: Total cost of the machinery 300000 Increase in working capital 40500 Total initial investment 340500 ANNUAL OPERATING CASH FLOWS: 1 2 3 4 incremental sales (units) 1350 1350 1350 1350 price per unit (with inflation at 3%)-$ 200.00 206.00 212.18 218.55 cost per unit (with inflation at 3%)-$ 100.00 103.00 106.09 109.27 Incremental sales revenue 270000 278100 286443 295036 incremental cost 135000 139050 143222 147518 incremental EBITDA 135000 139050 143222 147518 depreciation 100000 133332 44445 22222 EBIT 35000 5718 98777 125296 tax @ 40% 14000 2287 39511 50118 EBIT *(1-T) 21000 3431 59266 75178 add: depreciation 100000 133332 44445 22222 Annual cash flows after tax 121000 136763 103711 97400 working capital needed-15% 40500 41715 42966 44255 increase in working capital 1215 1251 1289 (assumed tht the increase in working capital takes place at the beginning of the year) Net Cash inflows after NWC investment 119785 135511 102422 97400 pvif @ 12% 0.8929 0.7972 0.7118 0.6355 pv 106951 108029 72902 61899 Cumulative of annual cash inflows 349781 depreciation rate % 33.333 44.444 14.815 7.407 TREMINAL CASH FLOWS: salvage value of the machine 25000 tax on gain on sale (40% of 25000 - 0) -10000 net cash flow from salvage value 15000 recovery of net working capital 44255 Total terminal cash inflows 59255 pv of terminal cash flows (59255*0.6355) 37658 NPV of the project at WACC = 12%: pv of annual cash inflows 349781 pv of terminal cash inflows 37658 pv of cash inflows 387438 initial investment 340500 NPV 46938 NPV of the project at a discount rate of 12 + 5 = 17%: Net Cash inflows after NWC investment 119785 135511 102422 97400 pvif @ 17% 0.8547 0.7305 0.6244 0.5337 pv 102380 98993 63949 51977 Cumulative of annual cash inflows 317300 PV of terminal value = 59255*0.5337 31624 pv of cash inflows 348924 initial investment 340500 NPV 8424 NPV of the project at a discount rate of 12 - 5 = 7%: Net Cash inflows after NWC investment 119785 135511 102422 97400 pvif @ 7% 0.9346 0.8734 0.8163 0.7629 pv 111949 118361 83607 74306 Cumulative of annual cash inflows 388222 PV of terminal value = 59255*0.7629 45206 pv of cash inflows 433428 initial investment 340500 NPV 92928 DECISION: The new line can be accepted as the NPV is positive even for the discount rate of 17%.

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